FABRICE TAYLOR IS A CHARTERED FINANCIAL ANALYST. TAYLOR.FABRICE@GMAIL.COMMAY 14, 2008
It's been almost a year since the bean-counting authorities in this country tried to nudge
income trusts into being a little more forthright about what they call distributable cash.
Did anyone listen? So far, it looks like the answer is: Not particularly. Trust investors should pay close
attention to this matter, though. Lots of trusts will be converting to corporations in the next couple of
years. A big change like that is the perfect opportunity for aggressive management to quietly reveal that
the economics of a business aren't nearly as good as the distributions implied they were.
Last July, the Canadian Institute of Chartered Accountants published (CICA) a 50-page door stopper that
tried to standardize the meaning of distributable cash flow, just as earnings are standardized under the
rules.
In theory, distributable cash is what a trust or fund can hand its investors without hurting the cash flows
of the business. In practice, if a company paid out all of its true distributable cash, its profits would grow
at around the rate of inflation, but no more, because it would have no money to expand.
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The CICA doesn't generally act unless it sees something alarming. You can assume that the freedom trusts
enjoy when it comes to wooing investors with high distributions or low payout ratios was cause for
concern. Given the dozens of companies that have cut or eliminated distributions for no reason other than
they were set too high in the initial public offering, that's understandable. Hence last summer's guidelines.
The institute is busy checking up on just how eager companies were to embrace its advice. The answer is
that about a third of trusts have. That ratio isn't based on financial statement analysis, either. It's based on
how many have adopted the CICA's jargon, notably "standardized distributable income." The cynic will
14/05/08 8:09 PM
reportonbusiness.com: The dirty little secret of income trusts: cash flow
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http://www.theglobeandmail.com/servlet/ ... y/Businessassume that the number of trusts that actually changed their accounting is a lot lower than a third. We'll
see once the CICA finishes its checkup.
Meantime, though, investors can do their own work. The guideline, at least the version that was
published, was really simple: Distributable cash is cash flow less cash spent on maintaining the assets.
The problem with this is pretty obvious. What if the company isn't investing enough to maintain its assets
such that they can maintain the cash they churn out?
The original drafts of the paper tried to account for that possibility, but there was too much opposition
from industry and not enough enthusiasm from investors.
So now the recommended calculation of distributable cash is basically cash flow less what the company
spent on maintenance, rather than what it should have.
The two can be very different. What you should spend doesn't just mean keeping a building in the same
state. It also means keeping it competitive with new buildings so that it can keep earning the same rents,
which means you have to improve the building just to stay even.
It's no coincidence that I used real estate as an example, because I think that's where some of the most
egregious examples of bogus distributable cash figures come from. I've seen trusts that define
distributable income as cash flow, and analysts who condone it, which is stunning. Real estate is hyper-
competitive. You not only have to maintain your buildings, you have to improve them so they can keep
up with new, state-of-the-art stock that competes for your tenants.
Yet most REITs reinvest a lot less than they depreciate, and some barely reinvest at all. They're easy to
spot: The balance sheet value of their properties falls. They'll tell you that's okay because the market
value goes up. Rubbish.
To see why, think of your own house. It might have been bought for $10,000 50 years ago (excluding the
land, which doesn't depreciate.) After 40 years, the standard depreciation for a building - its carrying
value - is zero if you don't do anything to it.
But during that time, you will have upgraded your kitchen and bathroom twice, redone your roof a couple
of times, replaced your furnace and water tank at least once, rebuilt your fence and made all sorts of other
upgrades to keep it "competitive" with a new house, like added air conditioning or a second storey.
Because of inflation, you'd have spent more on maintaining your house than you paid for it - a lot more. If
you had a balance sheet, the value of your house would be higher than 50 years ago.
The same argument can be made of another industry that loves to cloud its economic condition: oil and
gas. It's a little trickier there, because even though reserves per unit might fall (i.e., you haven't
maintained you assets), higher commodity prices skate you onside. But be careful: Reserves have to be
replaced and the cost of doing that rises in lockstep with the cost of oil and gas.
So don't count on the rule makers to keep corporations honest. Protect yourself. It starts by being highly
skeptical of what they tell you.

Indeed, based on two days of trading for Eveready Income Fund, the market regards payment in new units as about 20% less attractive than cash distributions from the fund "that provides industrial and oilfield maintenance and production services to the energy, resource, and industrial sectors."

The test case occurred this week. After the markets closed on Wednesday, Edmonton-based Eveready issued a four-and-a-half-page statement detailing its 2008 growth plans and the approval of "strategic changes to distribution policy." As with a number of releases, the first almost two pages were given over to spin. The content came later on.

The spin:

Eveready, which went public via a reverse takeover in April, 2005, would be spending $78-million on capital this year and generate more than $600-million in revenues, up from an estimated $515-million in 2007.

The content:

As part of its plan to "maximize the retention of operating cash flow to reinvest in growth," it was planning to eliminate its current monthly cash distribution of 6¢ per unit (or 72¢ a year) replacing it with a quarterly "in-kind" distribution of 18¢ per unit (or 72¢ annually). Paying distributions "in kind" means unitholders will receive additional units instead of cash.

"The market has been sending us a strong signal that our current distribution policy is not the most effective use of our cash," said Peter Lacey, chairman. "... Reinvesting the fund's cash in growing our business will maximize Eveready's long-term value. Essentially, our new distribution policy will provide the benefits that a corporation enjoys of being able to reinvest its profits in growth, yet retains the positive flow-through tax characteristics of an income trust until our likely conversion to a corporation in 2011."

And paying in-kind distributions would allow Eveready to retain more than $60-million in operating cash flow, as well as avoid the need to raise capital -- a move Lacey said would "be very dilutive to existing unitholders."

If that was the thinking, the market took a different view. The price of the units fell, a move that would make an equity issue even more dilutive.

Indeed, Diane Urquhart, an independent analyst, argues that converting to an in-kind distribution "is effectively a distribution cut, since the investors owning income trusts for cash income are now forced into the lesser-value proposition of substituting a certain monthly cash income with the uncertain cash realized from the sale of the additional shares received in kind each quarter. They need the cash."

Urquhart isn't that surprised. She argues the income trust model works only because "retail investors are willing to pay higher price multiples for cash distributions received than for the earnings that are retained in the corporation."

At week's end, Eveready (EISu/ TSX) units closed at $3.86. On their first day of trading in April, 2005, they closed at $3.31.

Reuters reports in "Trinidad Energy Services Trust to convert to corporation":
"Canadian oil drilling contractor Trinidad Energy Services Income Trust said on Thursday [January 11, 2008] that it will convert to a corporation and cut its distribution payout in advance of Canadian legislation to start taxing income trusts in 2011.

Trinidad said it is cutting its monthly distribution to 5 Canadian cents per unit, payable Feb. 15. The monthly distribution in December was 11.5 Canadian cents.

Trinidad said the change will also remove foreign ownership caps, scrap a structure that sets limits on growth, and allow increased capital investment, the company said."

Trinidad Energy Services Trust is the 87th income trust to cut significantly or suspend its distribution, as shown in the tables below. 74% of the energy service trusts have cut or suspended their distributions and 36% of all energy and business trusts have now cut or suspended distributions. The average distribution decline amongst the 87 income trusts that have cut or suspended their distributions is -58%, which coincidently is the % cut in the Trinidad Energy Services Trust case.

Larry Elford
Reuters reports on December 19, 2007, "in light of expected business challenges in 2008, the Board of Trustees and Management [of PRT Forest Regeneration Income Fund] believe it is prudent to reduce monthly distributions from the Fund to bring them in line with the anticipated reduction in PRT's operating cash flow. Accordingly, the Fund will reduce its expected monthly distribution from $0.07 to $0.046 per month ($0.84 to $0.55 per year annualized), effective with the January 2008 distribution declaration." This is a distribution cut of -34%.

PRT Forest Regeneration Income Fund is the 83rd income trust to cut or suspend distributions. 34% of all income trusts have now cut or suspended distributions, which is a statistically significant % for an investment product that was marketed to seniors and other retail investors whose investment objectives are income and preservation of capital. This is a micro-cap business that was not a suitable investment in the format of an income trust targeted to the seniors market where retirement security is pre-eminent.

(advocate comments........Many income trusts also fall under the category of "knowingly tainted" products, manufactured to standards almost designed to fail from the outset. But in a self policing investment industry, all is fair, until proper regulations are applied to this industry)
The track record of far too many of these shows a clear pattern of abuse of the client interests in the name of underwriting fees alone.)

IPO Investors Capital Loss -$174 Million,
While Promoters Made $174 Million Cash Upfront and Others Earned $62 Million of Fees

On November 6, 2007: Primary Energy Recycling Corporation has suspended its distribution after having warned about the possibility on September 21, 2007.

The November 6, 2007: Reuters News report says:

"Primary Energy Recycling Corporation (TSX: PRI.UN) has received preliminary inventory adjustment information from the site host of its Harbor Coal facility. If this information proves to be accurate, which the Company believes will be the case, the Company's financial results for the period ended September 30, 2007, will demonstrate failure to comply with the PERC Consolidated Leverage Ratio covenant and cause a default under the Company's senior debt Credit Agreement. Under the terms of the Credit Agreement, the Company will be precluded from paying interest to holders of its Separate Subordinated Notes and from making distributions to holders of its enhanced income securities ("EISs") unless such default is waived by Senior Lenders. This situation results from the cumulative effect of poor financial performance at the Harbor Coal facility during the past four quarters and the financial impacts of the unplanned outages at the North Lake facility earlier this year."

On May 18, 2007: just 21 months after its IPO, Primary Energy Recycling cuts its distribution by 30% due to operational issues and the need to comply with various financial covenants. The company said cash flow from operations is below expectations due to negative inventory adjustments at the Company's Harbor Coal LLC facility. Also, there is lost revenue and increased maintenance expense associated with a steam turbine generator failure at the Company's North Lake Energy Project.

Primary Energy Recycling is an Enhanced Income Security similar to an income trust. This is one of the eight hybrid securities comprised of a common share and a subordinated note stapled together, that were specifically designed for issuance in both Canada and the U.S. Enhanced income securities are considered an alternative to the income trust model, where the new income trust tax comes into effect in 2011.

This is a case of American businessmen assembling industrial facilities for the purpose of selling them to individual Canadians in the form of a 'Made-in-Canada' income security. Primary Energy Recycling, headquartered in Oak Brook, Illinois, operates four wholly-owned recycled energy projects and a 50% interest in a pulverized coal facility supplying coal to the steel industry. The recycled energy facilities capture and recycle waste energy from industrial processes and converts it into electricity and thermal energy for its customers use.

The retail investors who invested in Primary Energy Recycling have now lost all of their income, and they have also suffered a capital loss of - 56% or - $174 million since the initial public offering 26 months ago. At the time of the IPO, this income security was marketed on the basis of a stable cash yield of 11% from a stable utility business. The initial distribution of $1.10 per unit was close to 4 times the four quarter trailing income and interest per unit at the time of the IPO.

The American management did not have any maintenance expenditures in its estimated distributable cash estimate in its prospectus despite capital assets of close to $260 million and annual depreciation expenses of $30 million annually. Now one of the reasons for distribution suspension is increased maintenance expense associated with a steam turbine generator failure at the Company's North Lake Energy Project, causing the distributions to be cut.

As is the case with virtually all the income trusts and enhanced income securities, this was a vendor sell-out, and not one dollar raised from the public went into the treasury for investment in R & D or future growth. While the new investors have lost -$174 million, the vendors still have a profit of $202 million, of which $174 million was received in cash upfront. The vendors had assembled the business assets with a book value of about $49 million just prior to the Canadian IPO.

As was the case for most income trusts, the fees for the restructuring and IPO of Primary Energy Recycling were exorbitant:

the underwriting fees were $12 million, credit restructuring fees and penalties were $46 million and other expenses were $4 million. The total fees were 20% of the total new equity and debt raised!

In addition to the major bank-owned dealers being the underwriters, most of the same banks were also the new creditors for Primary Energy Recycling. There was much to be gained from the banks' involvement, while the duty of care owed to seniors by the bank owned dealers' financial advisors seems to have been forgotten.

As is generally the case in the Canadian income trust market, there was no prominent disclosure on the amount of return of capital in the marketed 11% cash yield!

Page 1 of the prospectus clearly said "The Manager will manage the businesses with the objective of providing holders of EISs with stable and sustainable cash distributions in the form of interest payments on the Subordinated Notes and dividends on the Common Shares."

The Ontario Securities Commission, chaired by David Brown at the time, approved this prospectus despite acknowledgement that income security cash yields were deceptive by OSC senior legal counsel Paul Hayward in an article he published in the Canadian Tax Journal during 2002. Paul Hayward called the Income Tax Act of Canada complicit to the income trusts deception.

Also, David Wilson, the current Chairman of the OSC, supervised Scotia Capital's participation in the underwriting syndicate for Primary Energy Recycling in August 2005, before he started his OSC Chairman job on November 1, 2005.

Primary Energy Recycling is the 23rd income trust or enhanced income security to suspend its distributions.

It is the second one in the past 24 hours, with Cinram International Income Fund being the other one.

Now 9% of income trusts have suspended their distributions and 32% have suspended or significantly cut their distributions.

“ Chapter 1 : What is an income trust?
An income trust is an investment that is designed to distribute cash to investors. It shares the features of a number of other types of investments. ..” We respectfully suggest that the OSC clarify that these distributions may be partially or substantially a Return of Capital. By failing to disclose this , the OSC conspires with Bay Street that the distributions can be thought of as “yield” in the conventional understanding of the word.

Canadian Business Magazine
October 23 - November 5, 2006
Matthew McClearn
Knitting and crocheting enthusiasts will tell you that making sweaters and scarves is a great way to relieve stress. The same has sometimes also been said of income trusts: ideally, they¹re supposed to pay investors a predictable stream of income from a stable business. And calm is the defining characteristic of a small rural community like Listowel, Ont., with its 5,900 souls and surrounding farmland. Yet somehow, these three ingredients combined to create a nightmare for investors who bought into the Spinrite Income Fund.
Spinrite, a yarn manufacturer, has for decades been one of Listowel¹s largest employers, rivalled only by a Campbell¹s food plant. The town¹s tallest buildings are churches, and Mennonites move about in black horse-drawn buggies. That income trusts made it here is testament to just how pervasive they¹ve become. It¹s a world apart from the Byzantine wheeling and dealing of Wall Street and Bay Street, which paid the town several visits in recent years. Listowel may seem an unlikely destination for investment bankers, institutional investors and analysts‹but much is possible when stock markets and hobby fads converge.
Though the official line places Spinrite¹s founding in 1952, a trip to the Stratford-Perth Archives reveals that the company¹s roots stretch back to just before the First World War. According to local history and folklore, German immigrant Max Becker was on his way to set up a wool-spinning and dyeing shop on the shores of Lake Huron. But a fateful encounter with six Listowel businessmen, each of whom offered him $1,000 to set up in their town instead, convinced him to found Perfect Knit Mills on the banks of the Maitland River. He was just in time to capitalize on massive wartime demand for wool to manufacture soldiers¹s uniforms. That made Becker rich. As a local newspaper noted decades later: ³Mr. Becker was a man whose timing was good.²
Becker sold out in 1933, and the new owner renamed the company Maitland Mills. It again enjoyed strong demand during the Second World War, but subsequently suffered three unprofitable years and eventually folded. A member of a prominent local family, David Hay, came to the rescue. He cobbled together new investors, bought Maitland¹s assets and founded Spinrite Yarn and Dyers Ltd., in 1952.
Through a combination of workaholism and constant investment in new technology, Hay built Spinrite into one of North America¹s largest yarn manufacturers. Hay explained to a local newspaper in his later years: ³We have taken out machines only four or five years old and replaced them with better, more efficient models.² But toward the end of his life, he despaired as his
customers in the Canadian textile business faltered. They couldn¹t keep up with American competitors, let alone those in developing countries.
Upon Hay¹s death in 1985, his two sons, Robert and Douglas Hay, took over. The latter presided over Spinrite¹s declining commercial yarn business, which dried up during the 1990s as clothing manufacturers moved offshore to reduce labour costs. Robert Hay, meanwhile, rescued the company yet again by diversifying into craft yarn‹basically the balls of yarn you see at craft and department stores. He bought up or licensed brands such as Phentex, Patons, Bernat and Lily during the 1990s.
In 2002, the company consolidated its dispersed warehouses in a new manufacturing and distribution centre. Henceforth, it concentrated on craft yarns, pitting itself against U.S. competitors such as Caron International, Coats & Clark and Lion Brand Yarn Co. (Commercial yarn operations ended in 2003, by which time Douglas Hay had left‹leaving his brother as the lone
shareholder.) Spinrite became Canada¹s yarn leader by buying out competitors, and grew its U.S. market share to nearly one-fifth.
By early 2004, Robert Hay wanted out. His two adult children showed no interest in running the business, and he hoped to retire. So that January, he sold Spinrite for about $81 million to a partnership led by New York based private equity firm Sentinel Capital Partners. (Sentinel invested US$19 million.) Hay said at the time: We are confident that by working together with Sentinel we will be able to further develop our business. As to how exactly the business would be developed, however, little was said.
Private equity firms make some people nervous. For decades, detractors have accused them of hijacking weak companies, boosting their short-term cash flow, piling on debt and then flipping them to unwary public investors. But academic studies consistently found evidence that reverse leveraged buyouts (a popular private-equity maneuver, and one Spinrite was about to experience) actually performed as well as‹or better than‹other types of transactions. This year, a study by Harvard University professor Josh Lerner and Boston College¹s Jerry Cao argued private equity firms get a bad rap, but offered one caveat: firms held by private equity for less than a year before being spun out performed far worse than average thereafter.
Sentinel certainly saddled Spinrite with debt. Whereas Spinrite had just $4.8 million of it in January 2004, the leveraged buyout increased that more than eightfold. Scotiabank provided most of the credit; Norwest Mezzanine Partners, a Minneapolis-based debt provider, contributed $10 million.
Short-term cash flow also surged, thanks to Sentinel¹s timing‹which was as uncanny as Becker¹s had been nine decades earlier. It so happened that the purchase coincided with a knitting and crocheting craze across North America.
Celebrities such as Cameron Diaz and Sarah Jessica Parker came out as knitters, providing much-needed publicity. Young women across North America did, too. They were partly attracted by so-called fancy yarns‹jazzier products featuring unique colours and unusual textures like feather and bouclé‹that even novices could use. We had so many people making these very easy scarf projects as Christmas gifts, says Mary Colucci, executive director of the Craft Yarn Council of America, an industry trade association. It drove sales tremendously. Retailers rejoiced; for example, Michaels Stores Inc., based in Irving, Texas, enjoyed a surge in same-store sales of yarn during 2004.
Fancy yarns generated higher margins, so Spinrite enjoyed a remarkable recovery through 2004. Our focus went to just being able to ship product, says CFO Ryan Newell. We ran a lot of overtime at the facility trying to keep up with demand. All told, Spinrite earned record revenue of $105 million that year.
Hay¹s replacement as CEO was Dario Margve. A graduate of the United States Military Academy at West Point, N.Y., Margve built his career with various management positions at Nestle S.A. in the 1980s. During the 1990s, he worked with a private equity firm to develop the business of J. B. Williams Co., a purveyor of personal products including fading brands like Aqua Velva and Brylcreem. Brands play an important role in the craft-yarns business, says Margve. My entire background is in consumer products, primarily in sales and marketing, so I thought I could bring some expertise in that regard. He started at Spinrite in August 2004 with a base salary of $500,000.
By then, Sentinel already had a plan for Spinrite. It had been in discussions with underwriters about spinning off the company as an income trust. Sentinel had held some investments for more than seven years, but not this one. Was this the dreaded ³buy and flip² that investment bankers warn their children about?
The conventional wisdom is that mature businesses with stable cash flows and little need for capital expenditures are ideal candidates to become income trusts. Highly cyclical or seasonal businesses‹or ones requiring extensive capital expenditures‹need not apply. Spinrite's prospectus emphasized the yarn industry¹s even-footedness, and observed that there hadn¹t been a downturn in 10 years. Indeed, between 2000 and 2003, its craft yarn sales consistently ranged between $55 million to $56 million. The brands had been around a long time, says Margve. The competitive base was limited‹the same players had been there for years. Barriers to entry were high. And unlike the commercial yarn equipment David Hay had upgraded often, Newell says craft yarn machinery hasn¹t changed much in 20 years. Capital expenditures would be small, they believed.
Had everyone followed the above logic, things mightn't have turned out so badly. But Spinrite also predicted its unprecedented surge in revenues would continue. Why? For one thing, North America¹s population was aging. That meant more
knitters, management reasoned, because ³the average knitter is female and over 50 years old. Meanwhile, young women‹including college students‹flocked to the craft thanks to the sudden popularity of fancy yarns. And due to deteriorating global security, North Americans claimed to be spending more time with family and friends. This cocooning trend, the prospectus posited, meant that individuals are also spending more time on crafting activities such as hand knitting and crocheting.
A great deal rode on these assertions. Income trusts pay their distributions out of a vaguely defined concept called distributable cash. This generally refers to the cash generated by the underlying business minus typical expenses like operating costs, taxes and capital expenditures, though there¹s no standard method of calculating it. Management claimed Spinrite could generate more than $25 million a year in distributable cash. That assumption helped drive Spinrite¹s enterprise value to about $301 million, almost four times what Sentinel paid a year earlier.
But in arriving at that calculation, Spinrite plugged in the 2004 sales of $105 million, which were unprecedented in the company's history. Most of the metrics or financial aspects of the IPO were negotiated between [Sentinel] and the underwriters, says CFO Ryan Newell. But I can say that it was normal for an income trust being marketed at the time to take the most recent 12-month activity and reflect that in the prospectus as the basis for valuation. Some critics, however, condemn that approach as unduly aggressive. They set the distribution too high, says Diane Urquhart, an independent analyst.
Urquhart (who once worked for Spinrite¹s lead underwriter, Scotia Capital Inc., and is now one of its most vocal critics) says the underwriters shouldn¹t have allowed it. In my years in the business, if a company produced a hockey stick forecast, you didn¹t price it on the hockey-stick high, she says. If a company sets an aggressive distribution and then has to cut it, it's going to suffer damages to the stock Spinrite is symptomatic of a very serious structural problem with income trusts, and the high risks in that structure.
Robin Schwill, a lawyer with the Toronto firm Osler, Hoskin & Harcourt, says such decisions ultimately must lie with management, not the underwriters. Who's best to know? It's going to be management of the enterprise, he says. As long as they're putting forward prospectuses that comply with securities legislation and make full, true and plain disclosure of the circumstances, I don't think there's any requirement for‹nor would the market want‹somebody to step in as an intermediary.
Scotia spokesman Frank Switzer agrees. People looked at the industry and the solid history of this company, looked at who its customers were, and made decisions based on that, he adds. Everybody has to remember that income
funds are still equity investments subject to a company¹s performance. It's not like a bond.
Prospectuses are often dismissed by investors, partly because prospectuses read a lot like technical manuals. But investors ignore them at their peril. In addition to the usual boilerplate warnings about unforeseeable events, Spinrite's revealed specific concerns. One was that nearly two-thirds of Spinrite¹s recent revenue gains came from two customers. If either of them fell on hard times, Spinrite's growth spurt could end in a hurry.
Spinrite¹s prospectus also mentioned that most of the growth came from fancy yarns. But it pointed out that consumer tastes and fashion trends are fickle. An employee of one Toronto yarn shop (who requested anonymity) explained that manufacturers risk their products falling out of favour. It's all about fads, he said. Knitting will become a fad, and then it will go into crochet, and this year felting is very popular. Either you get lucky and it¹s still in, or you¹re very unlucky and you¹re stuck with warehouses full of stuff.²
Perhaps the biggest risk was that the IPO saw Spinrite pile on even more debt. It intended to pay off its outstanding loans and enter into a new credit agreement with a syndicate that included Scotiabank, CIBC and the Bank of Montreal. Total debt would rise to $67.7 million‹the highest on public record. Of course, that money came with strings attached. One debt covenant proved particularly significant: Spinrite promised to maintain its ratio of debt to earnings before interest, taxes, depreciation and amortization (EBITDA) below 2.5:1. (This ratio theoretically shows how many years of operational earnings are needed to pay off company debt.) We were leveraged very similarly to other income trusts that went to market around the same time we did, which was 1.5 times EBITDA, says Newell. In other words, at the time of the IPO, Spinrite was well under the 2.5:1 limit. As long as the business is operating the way it's supposed to, that¹s an acceptable ratio. If the business encounters difficulties, there's not a lot of leeway there.
If these risks kept investors awake at night, it didn't show. On Feb. 8 2005, the oversubscribed offering raised $202.9 million, $181 million of which was used to buy 80% of the operating company, Spinrite Inc. Sentinel retained a 13% interest.
This transaction was highly lucrative for its backers. Sentinel made a
killing: it received US$109 million in cash, a 474% return on its original investment, making this, by far, the most lucrative of the five deals it had executed the preceding year.
Transaction costs totalled nearly $14.7 million. Much of that went to the underwriting syndicate (along with Scotia Capital, the other members included CIBC World Markets, BMO Nesbitt Burns, RBC Dominion Securities and TD
Securities). Riches flowed into management's pockets, too. Margve received nearly $2 million in cash‹plus another $1.5-million worth of subordinated units‹from Sentinel. The justification was his performance, but he¹d been on the job just six months. And he was promised $3.1 million more in cash, and more subordinated units, during the following three years if he stayed on as CEO. Other executives received lesser amounts.
That left investors. They received trust units at $10 a pop, and the prospect of receiving $1 of income per unit each year derived from Spinrite¹s future yarn sales. Though a significant number were retail investors, institutional investors also jumped on board. Bloom Investment Counsel, once described by investment guru Gordon Pape as one of Canada¹s leading experts on income trusts, bought significant amounts for funds it managed, such as the Citadel Diversified Investment Trust. Manulife Financial Corp. bought several of its Elliott & Page mutual funds. The Globe and Mail dubbed it the strangest offering of 2005. It only remained to be seen whether Spinrite could deliver on its promises.
Just after the February 2005 offering, American domesticity maven Martha Stewart walked out of a federal prison camp in Alderson, W.Va. wearing a poncho knitted by a fellow inmate. Spinrite and Lion Brand both speculated publicly that the inmate had used their yarns. She actually used Lion¹s product, but Spinrite declared ³Martha Poncho Madness Month and produced a pattern so that customers could make a similar item using its Bernat Galaxy yarn.
It was indeed a time of madness. Spinrite¹s sales continued at a frenetic pace during the first nine months of 2005, as retailers stocked up on yarns in preparation for a blockbuster Christmas. Spinrite had to fly in raw materials and outsource some production to other manufacturers. Investors drove its units to a high of nearly $14 that summer. Scotia Capital equity analyst Chris Blake was gung-ho, issuing reports that consistently forecast increases in the value of Spinrite¹s units. In September 2005, Margve increased distributions by 6%, to $1.06 a year. Everything seemed to be going as planned.
But they were all mistaken.
In the fall, craft retailers soon discovered that sales during the crucial Christmas season weren't nearly as buoyant as anticipated. For example, A.C. Moore Arts & Crafts Inc., based in Berlin, N.J., saw yarn sales plummet by 30% in the second half of 2005. Jo-Ann Stores Inc., based in Hudson, Ohio, also noticed unsold yarn piling up. They responded by slashing orders‹and dumping the stuff at liquidation prices.
One of Spinrite¹s smaller customers, Lewiscraft Corp., based in Brampton, Ont., couldn¹t handle it. The 90-store chain applied for court protection from creditors at the beginning of this year. Of Lewiscraft's nearly 150 suppliers, it owed Spinrite the most‹some $600,000. Meanwhile, turmoil at Spinrite¹s other customers
continued. In the three months ended April 29, Michaels' yarn sales were down 38% from the same period a year earlier. Jo-Ann lamented a significant deterioration in yarn and quickly replaced top executives.
Manufacturers felt the sting immediately. Spinrite's sales for the final quarter of 2005 plummeted by more than a quarter compared to the previous year. Margve ushered in 2006 by cutting 51 jobs and trimming production. Scotia's Blake, however, remained upbeat. And another analyst, Duff Kovacs of Clarus Securities, commenced coverage in January. Spinrite's units then traded at $6.90, but Kovacs thought they would return to $10. He called it a speculative buy. Bloom Investment Counsel was apparently in a speculative
mood: during the first three months of 2006, it acquired more Spinrite units for its Citadel HYTES Fund, even as its existing holdings dwindled in value. Nobody saw what was coming. I guess we shouldn¹t have been surprised says Colucci at the Craft Yarn Council. But our industry had never experienced this before.
Finally, horror set in. When Spinrite revealed its first-quarter results that spring, sales were just more than half what they had been a year earlier. There was no way its cash flow could cover the generous monthly distributions, so those were cut in half. The unit price imploded, and the analysts slashed their price targets.
Remember the debt? Spinrite quickly ran afoul of its covenants, forcing management to renegotiate them with bankers. In May, they reached an agreement that included a reduced credit limit, relaxed debt-to-EBITDA covenants and a one-year extension to repay borrowed money. Spinrite sold all of its foreign exchange hedge contracts for $5.1 million and used the proceeds to reduce debt. Management figured this would provide enough breathing room.
But it wasn¹t enough. In June, Spinrite eliminated distributions entirely. By September, its units traded at an all-time low of 80¢. Since its units had lost most of their value, Spinrite¹s market capitalization was grossly out of whack with the enterprise value on the company¹s books. Spinrite decided to revise in August, writing down its assets by $160 million. Simultaneously, management revealed that Spinrite was again in danger of violating its debt covenants. During a conference call, Kovacs asked whether management would seek protection from creditors under the Companies¹ Creditors Arrangement Act. Newell denied that. 'We feel it can generate enough cash flow to service the debt and be able to offer a proposal to the banks to get our debt down to what they believe is an acceptable level,' he said. But with unit prices around $1, Kovacs wasn¹t alone in wondering about Spinrite's future. In an August report, Scotia's Blake fretted about how little cash Spinrite had left. The most encouraging thing he could say was that the company is worth more as a going concern than broken up and liquidated. At press time, negotiations continued.
In a Lewiscraft store in a drab subterranean mall in downtown Toronto, a wall of brightly coloured Patons and Bernat yarns sells at half price. Lewiscraft is no
more; a receiver liquidated it this summer and 595 employees lost their jobs. Now in the hands of an agent, its few remaining stores are just one venue where knitting and crocheting enthusiasts can pick up yarn dirt cheap. Colucci says members of the Craft Yarn Council expect sluggish sales to continue until next fall.
Spinrite's ownership structure changed in recent months. Bloom Investment Counsel bailed out, while Royal Capital Management Corp. (not affiliated with RBC Royal Bank) began purchasing units in July. By the end of September, RoyCap had acquired a 16.75% stake, making it Spinrite's largest shareholder. It claims this is for investment purposes only, and that it hasn't reached any agreement with management. A RoyCap spokesman declined to comment on the company's intentions. Notably, however, on its website, RoyCap calls itself an expert in financial reengineering for companies in crisis.
What the hell happened? Looking back, Margve believes one contributing factor was that the yarn business failed to convince newcomers to stick to their knitting. For whatever reason, they didn¹t continue to the next level, he says. They didn't make sweaters and afghans. They got bored, and they left. He doesn¹t think his team was to blame. But having experienced both the knitting craze and its implosion, Margve and Newell agree the income trust structure proved inappropriate for Spinrite. In hindsight, should a business experiencing that kind of fluctuation be an income trust? Newell says. No. That's a given.

The original vendors of income trusts to seniors at $10 per unit are now buying them back at $2.25 and under. Here is a National Post article on the September 5, 2007 Spinrite Income Fund buyback by New York-based Sentinel Capital Partners. What a rip-off of the Canadian public, facilitated by the major banks and their subsidiary investment banks! Another example of an original vendor buyback is Associated Brands Income Fund, sold to the public by Torquest Capital Partners (owned by bank private equity divisions) at $10 per unit and bought back by this original vendor at about $0.80 on April 3, 2007.

Today's National Post article, "Sentinel tries to weave magic with Spinrite takeover offer," gives this statement from a prominent income trust closed end fund portfolio manager: "It's a smart trade," said Sandy McIntyre, a fund manager at Sentry Select Capital Corp. "You've got to admire smart investors. And you've got to admire professionals." "Is it a good solution for investors? Absolutely," he said. "They're bailed out, they get to take their capital off, there's been a good run in the market, its probably not the only investment you've got, and you've made money elsewhere."

Spinrite Income Fund IPO investors lost -78% or -$158 million on the February 8, 2005 IPO. Meanwhile, Sentinel Capital Partners received a $107 million cash profit upfront on their one year investment of $31 million; investment banks (Scotia Capital, CIBC World Markets, BMO Nesbitt Burns, RBC Dominion Securities and TD Securities) made $12 million of upfront fees; lawyers and accounting firms made another $5 million of upfront fees; and, 6 Spinrite managers received cash bonuses paid over 3 years regardless of performance of $15 million. Sentinel Capital Partners bought the Spinrite business in February 2004 for $79 million, $31 million of their own money and $48 million debt financed by Scotiabank and Norwest Mezzanine Partners. The IPO market valuation at February 2005 was $254 million. The September 5, 2007 buyback price is $57 million. In my opinion, the Spinrite Income Fund IPO was sold at a grossly inflated price to the investing public, based on an excessive distribution per unit that no reasonable person could have said was sustainable. The distribution did not exceed the net income of Spinrite at the time, but the net income was the highest it had ever been and more than four times its historical average at the time of the IPO.

Sentinel Capital Partners substantially raised the amount of third party debt leverage at Sprinrite from $6 million at February 2004 to $38 million by September 2004 and $48 million at the time of the February 2005 IPO. Concurrent with the IPO closing, Spinrite repaid its existing credit facilities with Scotiabank and entered into the New Credit Facility with a group of Canadian chartered banks, including Scotiabank, CIBC and Bank of Montreal. A portion of the IPO proceeds was also used to repay a portion of the indebtedness owing to Scotiabank.

By March 2006, Spinrite Income Fund slashed unitholder distributions by 55 percent and warned it may not meet debt covenants because of weaker than expected sales. In May 2006, Spinrite renegotiated with their banks a reduced credit limit, relaxed debt-to-EBITDA covenants and a one-year extension to repay borrowed money. Spinrite sold all of its foreign exchange hedge contracts for $5 million and used the proceeds to reduce debt. Management figured this would provide enough breathing room. But it wasn't enough. In June 2006, Spinrite eliminated distributions entirely.

Matthew McClearn of Canadian Business wrote in his October 23 to November 5, 2006 article: "What the hell happened? Looking back, Margve believes one contributing factor was that the yarn business failed to convince newcomers to stick to their knitting. For whatever reason, they didn't continue to the next level, he says. They didn't make sweaters and afghans. They got bored, and they left. He doesn't think his team was to blame. But having experienced both the knitting craze and its implosion, Margve and Newell agree the income trust structure proved inappropriate for Spinrite. In hindsight, should a business experiencing that kind of fluctuation be an income trust? Newell says. No. That's a given."

Spinrite Income Fund is not an isolated case. There are 59 income trusts or 24% of the business and energy income trusts market that have suspended or significantly cut their distributions.

Diane Urquhart

Independent Analyst

Financial Post article:

Sentinel tries to weave magic with Spinrite takeover offer
Buying Back At Discount
Thursday, September 06, 2007
As ugly and tarnished as Spinrite Income Fund's existence as a publicly traded company may be, its privatization announcement is an
example of how savvy investors capitalized on the feverish boom in the soon-to-be-defunct income-trust market.
Sentinel Capital Partners, a New York-based private-equity shop, yesterday offered Spinrite investors $2.25 per unit, bettering
Tuesday's closing price of $1.51 by 74¢, or 49%. Sentinel knows this yarn company well: It was the financial sponsor that sold
it to the public at $10 per unit in its February, 2005, initial public offering. Essentially, it's buying back its old company at a big
discount to where it sold it to the public just a couple of years ago.
"It's a smart trade," said Sandy McIntyre, a fund manager at Sentry Select Capital Corp. "You've got to admire smart investors. And
you've got to admire professionals."
Both knitting as a hobby and income trusts as investment vehicles were all the rage when Sentinel sold 80% of its interest in
the company. By selling at the top of these two crazes, Sentinel's gross cash proceeds totalled US$109-million, which means it
made about US$90-million on the deal, according to a Sentinel press release at the time.

Previous post is the latest BottomLine article on the new CICA Guidelines for Management Discussion and Analysis disclosure on estimated distributable cash for income trusts . Al Rosen and I are quoted here, as is Kevin Dancey - CICA President and CEO, Kevin HIbbert, Standard and Poors Canada chief accountant, Brent Fullard - President CAITI, and Jack Mintz, former Economics Professor University of Toronto (now at University of Calgary).

I do not agree with the Jack Mintz comment on energy trusts, where there is depleting oil and gas reserves as they are extracted from the ground and sold. Jack Mintz says that it is appropriate in the case of energy trusts to put the entire cash flow into the yield calculation because the asset is not being replaced, it is being depleted. But, this is what causes the overvaluation, because the investor paid for the reserves in the ground so when he gets cash distributions, he is getting both income on his investment and getting his principal investment back. You need to know both components to determine the fair value of energy trust units.

A simple cash yield calculation is ignoring that the terminal value of the oil and gas wells are zero after all the reserves are extracted. Therefore, this simple cash yield calculation is inaccurate and inflates the current value of energy trust units, if the benchmark yield being used is close to the high yield junk bond. Only a complex present value of cash flows calculation using a fair internal rate of return and a terminal value of zero will produce the fair current value of an energy trust operating to deplete its entire reserve base.

www.lexisnexis.ca Vol. 23, No. 10 September 2007
Too little, too late, critics say of CICA text
By Jeff Buckstein
The Canadian Institute of Chartered Accountants (CICA) recently
issued what it and supporters believe is critical new guidance
aimed at obtaining consistent disclosure standards for
distributable cash by income trusts and other flow-through
entities. Critics charge, however, that it is too little, too late.
“Where was this five, six, seven years ago? Coming out at this
point – there are very few of these trusts still being floated,” says
Al Rosen, founder of Toronto-based Rosen & Associates, a
forensic and investigative accounting firm. Rosen also finds “very
troublesome” the notion being advanced that CICA’s prime
interest is protecting investors, particularly seniors. “This is so
outrageously not what they are doing,” he says.
Kevin Dancey, the CICA president and chief executive officer,
defends the CICA initiative, calling it “groundbreaking” and noting
that it provides investors with a framework to ask “a couple of
key questions: first, where did the cash come from, and second,
is the cash flow sustainable?”
It is important to have a common measure of distributable cash
so that all investors have a similar understanding of what is
meant by the term, agrees Jack Mintz, a professor of business
economics at the University of Toronto’s Rotman School of Management.
Other key areas the CICA guidance addresses include:
• The entity’s strategy for managing its productive capacity, along with disclosure as to whether that
capacity has been maintained;
• The entity’s strategy for managing debt, and the related impact, if any, on financing distributions; and
• The disclosure of any financial covenants – and the degree to which the entity is complying with such
covenants – that might restrict future cash flow distributions.
While some of its critics concede the CICA guidance hits the heart of the issue, they slam the institute for
not only waiting so long, but also because they feel any effect the guidance will be muted, since
investors have already lost much of the value of the income trusts they were holding.
But contrary to popular belief, the reason those values have dropped is not primarily the surprise
October 31, 2006 announcement by Finance Minister Jim Flaherty that distributions from all publicly
traded income trusts and limited partnerships would be taxed no later than 2011, alleges Rosen.
Brent Fullard, Canadian
Association of Income Trust
Investors
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“The big issue here” is that many income trusts acted as “Ponzi frauds and pyramid schemes” by virtue
of hyping high yields that in reality ended up “giving people back their own money” as part of the
advertised returns, he charges.
Kevin Hibbert, the Toronto-based chief accountant at Standard & Poor’s Canada, a provider of
investment research and data, disagrees with that assessment.
“I’m not sure an irreverent term like Ponzi scheme is fair or accurate to describe what the trusts are
doing. A lot of trusts have very good disclosure around the fact that a portion of the distribution is a
return of capital, as opposed to a return on capital,” says Hibbert, who co-authored a two-part report in
2006 that highlighted various accounting, financial reporting and analytical nuances with respect to the
measurement of distributable cash by income trusts.
Diane Urquhart, a Mississauga, Ont.-based investor and consulting analyst who worked in the investment
industry for more than 25 years, backs Rosen up. She consulted with him in 2005 to produce a report on
income trusts which concluded that many trusts had already declined in value and were a threat to
investors, primarily because they were substantially overvalued to begin with – thus leading to
significant cuts, or even the elimination of cash distributions.
In a letter to then Finance Minister Ralph Goodale, which is available through the federal Department of
Finance website, Urquhart wrote, “We contend that the rush to convert corporations to income trusts has
not been due to favourable tax treatment, but more to do with the ability of owners to obtain excessive
valuations through permissive distributable cash reporting and improper cash yield valuation
methodologies.”
The letter goes on to say the research conducted by Rosen and Urquhart found that 75 per cent of the
50 largest business trusts in Canada had cash distributions in excess of income by an average of 58 per
cent in the fall of 2005.
Hibbert, however, is not convinced that income is the right standard to measure distributions by. He
contends “the more relevant metric” to pay attention to is a distribution relative to cash flow as opposed
to accounting earnings, since the latter also includes accruals and non-cash items.
In an interview with The Bottom Line, Urquhart said the cash yield methodology used by the trusts was
“inaccurate and unacceptable.” She noted, for instance, that many trusts did not “set aside sufficient
cash from operations to maintain and replace capital assets that were necessary to stay in business.”
Just prior to Flaherty’s announcement last fall, Urquhart completed another study on her own and
concluded that while trusts had been overvalued by 55 per cent, only 14 per cent of that total was
attributable to beneficial tax treatment. The remaining 41 per cent involved other sources of
overvaluation, she says.
The idea that trusts are overvalued is “a totally false proposition,” charges Brent Fullard, president and
chief executive officer of the Canadian Association of Income Trust Investors (CAITI) in Toronto. “Who is
somebody to say something is overvalued? Value in a public market is free and open and determined by
a willing seller and buyer,” he says.
What is clear, however, is that the October 2006 announcement had “an immediate, negative impact on
the ongoing value of those trusts (causing) a permanent loss of value,” he contends.
Fullard says investors, many of them seniors, have lost $35 billion of their savings in the wake of
Flaherty’s announcement.
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Urquhart doesn’t buy that. She believes seniors in particular have been unwitting victims of many false
promotions involving trust yields, and thinks it is despicable that this group has been exposed to that at
this stage in their lives. She thinks the CICA should have stepped in as early as 2001, when income
trusts first began to rise to prominence as investment vehicles. Furthermore, she believes the CICA is
acting now only because of public pressure.
Fullard says this issue is being spun in a “spurious” way to “evoke the notion that seniors are being
misled,” although he agrees the reporting of some trusts likely needed “to be improved.” For that he
applauds the effort of the CICA and others who are “making belated attempts to correct these problems
in an effort to evolve the market and make it better.”
Dancey defends the CICA’s timing on this issue, noting that the institute responded quickly to the
Standard & Poor’s 2006 study, which “indicated the need for a framework” to address trust distributions.
It took time to formulate and finalize the guidance, he says, because “there were no similar guidances
around the world.”
Consequently, “it was very important from our perspective to listen to all of the various stakeholders”
including the “views of preparers, analysts, investors, regulators, etc., in putting this guidance together.”
Moreover, he notes, the guidance extends to various industries, including the oil and gas, real estate and
commercial sectors, thus adding to the time required to deal with those diverse elements.
The initial draft guidance was released in the fall of 2006, after being worked on all last summer, and
was finalized by the institute in July 2007, following a review of the comments returned to it last spring.
Another criticism of the guidance is that it is only aimed at Management Discussion and Analysis
(MD&A), rather than the financial statements, where it would presumably have greater impact. That is
the view of Rosen, who says the guidance merely ends up as a “nice to see part of the MD&A section”
rather than an “audited portion of an annual report.”
Moreover, he claims, “there is nothing in the way of teeth” to enforce this because the CICA “doesn’t
have the power to do it.”
Dancey says this initiative is earmarked for the MD&A because it is a non-GAAP measure, and as such is
not subject to a review by the Accounting Standards Board. “This is not an issue of GAAP, but a
performance measure that we thought was important to give some guidance to,” he emphasizes.
“We would like to think it’s going to be adopted by entities as they look at their disclosure
responsibilities . . . (and) that this will be an example of best practice to both CFOs and CEOs, and also
to audit committees as they make sure that the MD&A has fulsome disclosure. This is just another step
in the right direction in terms of coming up with an improved measurement of financial performance,”
Dancey adds.
Hibbert believes that overall, the CICA standards, in conjunction with the Canadian Securities
Administrators (CSA) National Policy 41-201 dealing with Income Trusts and Other Indirect Offerings,
“are quite good.” Moreover, the CICA and CSA collectively “address most of the reporting distortions that
we (S&P) identified in our report,” he notes.
But Rosen insists the guidance falls short on several counts, including the information it provides
investors. For instance, while the disclosure will say how much cash was spent to replace assets over the
course of the year, it doesn’t go so far as to say whether trusts are doing all they can to replace and
maintain assets, he says.
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Mintz doesn’t think that is necessary; in fact he believes that would be overstepping boundaries.
“I’m not sure you would want to have rules that force people to replace assets,” he says, noting that it
may be appropriate for some companies to wind down by distributing their assets.
For instance, Mintz points out, the key resource of an energy trust involving oil is a depletable asset,
which constitutes “a natural part of the yield.”
Consequently, “I don’t think the actual behaviour of the company should be regulated in that way. That
would be a mistake.”
Close
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Prices have dropped as North American inventories of gas have risen, the company said. There has been less demand for energy for cooling this summer, and there has been no “significant tropical storm activity” on the U.S. gulf coast that might have driven up prices.

The recent rise in the Canadian dollar didn't help, the company said.

Consequently, Paramount cut its distribution for July to 10 cents a unit, compared with the 14 cents it paid out in each of the past five months. Based on current natural gas prices, it said it expects to maintain distributions at this level for the “foreseeable future.”

Paramount said its strategy is to hold on to enough cash to maintain its production levels, and then distribute the rest to unitholders. The distribution had to be cut to “preserve sustainability” and strengthen the company's balance sheet in light of the low prices, it said.

Just four weeks ago Paramount raised more than $250-million by selling subscription receipts priced at $12.25 each. Each receipt entitled the holder to one unit, plus any distributions that occurred before the receipts were converted to units.

Diane Urquhart, an investor advocate and former research analyst who has been critical of the income trust industry, said Wednesday that “this is the fastest distribution cut after an offering that I have ever seen.”

She noted that Paramount's subscription receipt offering was a bought deal among 14 different investment dealers. “I find it hard to believe that 14 investment banks and the management and the trustees of paramount wouldn't have known 19 business days ago that their distribution was too high,” she said. “You shouldn't sell something [when] your balance sheet is so precarious that you're that close to deciding you need to have a cut.”

The prospectus for the Paramount offering said in several places that the distributions are “not guaranteed” and may be “reduced or suspended.” It also warned that the value of the trust's units could fall if the company can't meet its cash distribution targets.

Paramount made monthly distributions as high as 24 cents in the past three years.

I have the following comments on the CICA Canadian Performance Reporting Board's new Guidelines for "Standardized Distributable Cash," to be included in public income trust's Management Discussion and Analysis , released on July 18, 2007:

(1) This new standardized measure is not a new Canadian generally accepted accounting standard, but a guideline for the calculation and explanation of this non-GAAP financial measure to be included in the public income trust's Management Discussion and Analysis.

(a) Why does the Canadian Accounting Standards Board, controlled by the CICA and corporate/income trust industries, accept that the income trust industry was/continues to be permitted to publish a second set of financial reports, outside of Canadian generally accepted accounting principles? The new Guidelines assist investment experts, while still enabling a bifurcated market between professional investors and unsophisticated retail investors.

(b) Retail buyers, and most of their financial advisors, do not read Management Discussion and Analysis Reports, and they rely upon marketing materials that focus them on the cash yield measure. The cash yield exceeds the income yield in more than two thirds of the income trusts in the market, and this overstatement will not likely be reduced much by the new standardized distributable cash definition. The new so-called standardized measure provides no definition of productive capacity, so there is still wide latitude on the part of income trust managers and the investment banking/mutual fund industries to understate the long-term capital costs in the business and to market income trusts at inflated prices due to this deceit.

(c) There is no new accounting standard to specify income distributions and return of capital distributions necessary for seniors and other unsophisticated buyers of income trusts to determine the income yield of these securities bought for income purposes. This public disclosure is needed for seniors to be safeguarded from paying excessive and unsustainable prices for income trusts. 51 or 26% of all business income trusts have suspended or materially reduced their cash distributions.

(2) This new measure is too late to mitigate the $ 8 billion of capital losses borne by seniors in 50 business income trusts that have dropped more than 20% since their latest public offerings. These 50 business trusts are a quarter of the business income trust market and had average decline of 47%.

(3) This new measure does not mitigate the call for a criminal investigation, by the National Pensioners and Senior Citizens Federation, United Senior Citizens of Ontario and the Small Investors Protection Association, of the marketing materials containing the inaccurate and misleading cash yield measures that today's CICA Canadian Performance Reporting Board is attempting to correct. The Canadian standard for criminal conduct under S. 380 of the Criminal Code is whether there is an intent to affect the market price of stocks or anything that is marketed to the public through deceit. The absence of an accounting standard or MD & A guidelines for financial reporting of non-GAAP financial measures does not make deceitful financial reporting and marketing permissible.

* Market Cap Gain/Loss
= Estimate based on % gain/loss relative to last offering price in period X current market cap.

(4) Institutionalized public disclosure and audit committee approval of documents showing excess cash distributions being funded from such sources as, debt, prior period equity financings and the intended understatement of corporate expenses, is not a defense for deceit in marketing materials whose purpose is to entice seniors to purchase securities at inflated prices.

Chartered Accountants Recommend Better
Disclosure To Help Income Trust Investors

TORONTO, July 18, 2007 – Retirees and other investors in income trusts could see a clearer picture of their investment risk as a result of recommendations for reporting of income trusts’ distributable cash issued today by the Canadian Institute of Chartered Accountants (CICA).

Inconsistencies in how income trusts calculate distributable cash and other measures have made it difficult for investors to evaluate income trust financial results over time and compare them across entities. Canada’s Chartered Accountants are taking a lead role in resolving this issue with recommendations developed by the Canadian Performance Reporting Board (CPRB) for improved disclosure, transparency and standardization in the reporting of distributable cash in Management’s Discussion and Analysis (MD&A).

This new guidance complements a recently published Canadian Securities Administrators (CSA) policy statement by providing a standardized measure for reporting distributable cash and a disclosure framework that will assist preparers in meeting the objectives of the CSA policy.

“Up until now, the lack of consistent distributable cash calculations and disclosures among income trusts has led to significant confusion about what the term distributable cash represents,” said Kevin Hibbert, Director and Chief Accountant, Standard and Poor’s Canada. “The CICA’s new guidance, in combination with the new CSA policy, provides income trusts with much needed direction in how to improve comparability, clarity and consistency in the reporting of distributable cash.”

For Kevin Dancey, FCA, president and CEO of the CICA, the main issue is safeguarding investors. “As a leader in establishing best practices in reporting and disclosure, the CICA is filling this gap in financial reporting that has put investors in income trusts at undue risk. The focus of our guidance is to give investors information to answer two specific questions: Where did the cash come from that funded their cash distributions and, in arriving at the amount available for distribution, has the income trust made the investments necessary to maintain its operations.”

The term ‘distributable cash’ generally refers to the cash that an income trust could potentially distribute to unit holders. Investors use this information when assessing the entity’s ability to fund future distributions and to help value their investments. A standardized measure accompanied by disclosure about productive capacity and finance strategy will assist investors when making these assessments.

The CICA guidance recommends that income trusts report a new measure called “Standardized Distributable Cash” to improve consistency of reporting and comparability between entities. Together with other disclosures recommended in the framework, the new measure gives the industry a common methodology for providing investors with information to answer four key questions:

How much cash was generated in the period and where did it come from?
What is the entity’s strategy for managing productive capacity and to what extent has that capacity been maintained?
What is the entity’s strategy for managing debt (including long-term unfunded operational liabilities such as pension plans) and how does this impact distributions?
What financial covenants exist that might restrict future distributions and to what extent is the entity in compliance with those covenants?
Investors need this kind of information to properly understand and interpret what is meant by distributable cash – and to assess and compare investments. Indeed, with the passing of legislation to implement last fall’s decision to tax income trusts’ distributions – commencing in 2011 for existing trusts – disclosures of productive capacity management and finance strategies take on additional significance for investors as these entities make plans for how to deal with the post 2011 environment.

“By following this guidance, income trusts will provide their investors with transparent and comparable information on how their cash distributions are funded, as well as other related disclosures, such as the entity’s productive capacity history,” Dancey added. “CEOs and CFOs may also wish to consider this guidance when determining whether or not financial information in the regulatory filings is fairly presented for certification purposes and it may likewise be of assistance to audit committees making similar assessments.”

The CICA developed the recommendations after considering the comments of the income trust community and investors to draft guidance issued last fall.

Copies of this guidance (PDF) can be obtained from CICA’s Performance Reporting Resource Centre at www.cica.ca/cpr.

The Canadian Institute of Chartered Accountants (CICA), together with the provincial, territorial and Bermuda Institutes/Ordre of Chartered Accountants, represents a membership of approximately 72,000 CAs and 10,000 students in Canada and Bermuda. The CICA conducts research into current business issues and supports the setting of accounting, auditing and assurance standards for business, not-for-profit organizations and government. It issues guidance on control and governance, publishes professional literature, develops continuing education programs and represents the CA profession nationally and internationally. CICA is a founding member of the International Federation of Accountants (IFAC) and the Global Accounting Alliance (GAA).

Subject: Retail Investors in Income Trusts Duped Again
- Paramount Energy Trust Cuts Distribution
Just 19 Days After $251 Million Public Offering
Paramount Energy Trust has cut its distribution by -29%, just 19 business days after a $250 million secondary equity offering when the previous $0.14 distribution per unit was confirmed. Can reasonable people conclude that the 14 investment banks and Paramount Energy Trust management and trustees did not know 19 days ago that "there was higher-than-average North American natural gas inventories due to a lack of summer cooling demand and no significant tropical storm activity in the U.S. Gulf region," that would cause a material distribution cut shortly. This is the stated reason given by Paramount management for today's 29% distribution cut.

Paramount Energy Trust has declined -11% today and a total of -24% since the June 20, 2007 $251 million equity bought deal. The investors of this offering have lost $60 million in 19 business days. I wonder what percentage of the new offering book went to retail investors and mutual funds or closed end funds owned by retail investors?

"Units of Paramount Energy Trust sank more than 10 percent on Wednesday after the company cut its monthly distribution level. Units were down C$1.13, or 10.8 percent, at C$9.37 on the Toronto Stock Exchange.

The trust set its July distribution at 10 Canadian cents a unit, down from 14 Canadian cents a unit in June.

Paramount said higher-than-average North American natural gas inventories due to a lack of summer cooling demand and no significant tropical storm activity in the U.S. Gulf region made the adjustment necessary."

Reuters Market Wire, "Paramount Energy Trust Announces Closing of $250.5 Million Subscription Receipt and $75 Million Debenture Bought Deal Financing and Confirms June 2007 Distribution", dated June 20, 2007:
"NOT FOR DISTRIBUTION TO U.S. NEWSWIRE SERVICES OR FOR DISTRIBUTION IN THE UNITED STATES"

Paramount Energy Trust (TSX:PMT.UN) ("PET" or the "Trust") announced today the closing of its previously announced "bought deal" financing. At closing 20,450,000 subscription receipts (the "Subscription Receipts") at $12.25 per Subscription Receipt for gross proceeds of $250,512,500 and $75,000,000 aggregate principal amount of 6.50% convertible extendible unsecured subordinated debentures (the "Debentures") were issued (collectively, the "Offering")."

PET also confirms its distribution to be paid on July 16, 2007 in respect of income received by PET for the month of June 2007, for Unitholders of record on June 29, 2007, will be $0.14 per Trust Unit."

There is considerable carnage in the income trust market due to distribution suspensions and cuts, like this Paramount Energy Trust today.

* Market Cap Gain/Loss
= Estimate based on % gain/loss relative to last offering price in period X current market cap.

Income trusts have been marketed to seniors and other retail investors on the basis of their so-called sustainable cash yields.

Paramount Energy Trust is just another case of deceitful marketing by the financial advisors of investment banks, who put their own and their employer's financial interests ahead of their duty of care to seniors.

Barry Critchley of the National Post has written two columns on Stephenson's Rental Income Fund, where Scotia Capital lead an IPO sold to seniors and other retail investors for $10.00 on July 28, 2005 and where the same firm provided credit and a fairness opinion on a take-over offer of $6.875 in May 2007. One unitholder quoted in the National Post says: "There's something wrong here. It stinks. They are giving us the gears. How can they justify telling the retail investors to buy it at $10 in 2005 now they are telling them to sell it for less than $7."

This is yet another case where the Canadian bank-owned investment banks sold an income trust to seniors on the basis of a deceptive cash yield in the marketing materials, knowing at the time that the security was overvalued and disregarding their duty of care to advise suitable investments for their retail clients. The distribution of $1.10 per unit has been in place since the IPO, which was marketed on the basis of a 11% yield. At the time of the IPO, the 12 month trailing income per unit as of March 31, 2005 was negative ($0.11). My estimate of the income per fully diluted unit for the year ending December 31, 2006, excluding tax recoveries, amortization of intangibles and extraordinary items, is $0.32. Stephenson's Rental Income Fund's income statement and reported income per unit of a loss of ($28.32) for 2006 is incomprehensible to even the expert investor, let alone seniors and unsophisticated retail investors, who were sold this security by the bank-owned financial advisors. KPMG is the auditor.

Advocate comments on this post:

I have to agree with one of Canada's top forensic accountants on this subject (Dr. Al Rosen) who suggests that too many of these income trusts are nothing more than ponzi schemes to dupe an unsuspecting public. To see the amount of misdirection used in marketing these things, combined with the huge investment banking fees and underwriting fees makes one think that in addition to the ponzi scheme, the banks have a revolving door in which they loan money to these outfits, take out the equity in fees and commissions, sell the husk of the company off to shareholders based on a bullshit yield story, wait for the business to collapse and then repeat the procedure.

Add the fact that David Wilson, Canada's top securities policeman at the OSC is a veteran of the industry, and the very company that spawns many of these issues, and it is no wonder Canada is leading the race for first place in world financial scandals. One only wonders for how long the industry can continue to hide bodies such as this in closets, before the smell starts to alert the public.